As a module in the app, Know Your Worth assists you in determining the Economic / Intrinsic Value of a Company. The module consists of two sub-sections: Early Stage and Growth & Mature Stage Companies. This module helps a user to conduct Valuation of any Company in any Country and in any Currency.

This section elucidates terms, methodology, and models used in the app, which will help to determine the Economic / Intrinsic Value of a Company. The app uses the Perpetuity with Real Constant NOPAT Model to determine Residual Value and the model assumes that the Companies are being valued as a Going Concern.

The Economic or Intrinsic Value of Company is a Discounted Cash Flow (DCF) Valuation where the Cost of Capital discounts the Future Cash Flows in Perpetuity to arrive at the Present Value of Cash Flows. These Cash Flows consists of two parts:

• Cash Flows during the Forecast Period.
• Cash Flows Post Forecast Period (Residual Period).

The Value Augmentation of a Company is most pronounced during the Forecast Period. During the post Forecast Period – also referred to as Residual period – the assumption in the model is that the Company would not create any additional value since it would earn equivalent to its Cost of Capital. It is also assumed that the Company would be able to sustain its Net Operating Profit after Tax (NOPAT) in real terms post the Forecast Period.

The Cash Flows generated during these periods belong to Debt Holders and Shareholders. Thus the Economic or Intrinsic Value of the Company would thus be the sum of Equity and Debt Values, also referred to as the Enterprise Value of a business. The value of the Equity is referred to as Shareholder Value. Therefore:

1. Enterprise Value = Shareholder Value + Debt Value (includes all interest bearing obligations)


2. Shareholder Value = Enterprise Value – Debt (Further the Company’s Statement Of Affairs may also contain Non-Operating Balance Sheet elements such as Cash, Securities, Investments & Other Assets and Minority Interest & Other Liabilities that are not utilized for generating Operating Cash Flows which may need to be added or subtracted to arrive at Enterprise and Shareholder Value.)


3. Shareholder Value therefore is:
   • The Present Value (PV) of Cash Flows from Operations during the Forecast Period Plus
   • Present Value of Residual Value of the Company’s business, referable to the period beyond the Forecast Period Plus
   • Cash & Marketable Securities and Other Investments (The Income from these Investments should not be included in Cash Flows from Operations) Minus
   • Minority Interest and Other Liabilities Minus
   • Debt and Long Term Obligations.

Cash Flow from Operations is Operating Cash Inflows less Operating Cash Outflows. Cash Inflows is Operating Profit and Cash Outflows is Incremental Fixed Assets Investments, Incremental Net Working Capital (NWC) Investments and Income Tax.

The Cash Flow from Operations is estimated for each year in the Forecast Period, which is then discounted back to the present. The Cost of Capital or the Weighted Average of the Cost of Debt and Equity Capital (WACC) discounts the Cash Flows. In the App we use the WACC to discount the Cash Flows.

Table 1.1 demonstrates the computation of Present Value of Cash Flows for a Forecast Period of 5 years with a discount rate of 11%.

Table 1.1

The Cumulative Present Value of Cash Flows during the Forecast Period is 7007.9.

Prior to any Valuation, it is imperative to know the Number of years for which Valuation is to be based on. These years constitute the period for which the Company is expected to generate returns in excess of its Cost of Capital. This could be from a single year to 15 years and if companies have significant competitive advantage then these could be over 15 years and even go up to 30 years.

The model used in the App, assumes that post the Forecast Period, Incremental Investments would not create value and the Company will be able to sustain its NOPAT in real terms. The App permits the Forecast Period to be a maximum of 30 Years.

When using the App, enter the number of years for which the Valuation is to be based on. The maximum period of forecast in the app is limited to 30 years.

The starting point of estimating Cash Flows is Sales and the Growth Rate of Sales. The Sales is the Sales in the Prior Period and should exclude non-operating income.

The Prior Period is ideally the 12-month trailing period for which the data is to be entered, for instance June 30, 2017. In case data is not easily available for 12 months the user may enter the data for immediately preceding fiscal year – for instance, March 31, 2017.

The user should estimate the Sales for the Forecast Period either in Values or Sales Growth Percentage to Prior Period Sales. This can be done by estimating Compounded Annual Growth Rate (CAGR) or by a yearly percentage of growth.

When using the App, the user may enter either CAGR or different growth rates for each individual year. In case of start-ups, if the Sales were zero in the previous and or subsequent years, the user must enter zero and not a percentage until the time there are sales.

Operating Profit Margin (OPM) is the Earnings before Interest and Income Tax (EBIT), and after deducting Depreciation.

To arrive at the Operating Profit, all expenses including Depreciation should be deducted. The Operating Profit Margin should not include Other Income.

To compute the Cash Flow the user must also deduct Depreciation from Operating Profit though a non-cash item - however other non-cash items such as amortization of intangibles should not be deducted.

Further the user also needs to remember to deduct the Depreciation from Capital Expenditure to arrive at the correct Cash Flow.

A significant portion of the Shareholder Value is in the Residual Value. The Target Year (Last Year of the Forecast Period) Operating Profit is the key driver in computing the Residual Value, thus the user needs to carefully ascertain the Operating Profit / Margin for the Target Year.

When using the App, the user must enter the Operating Profit / Margin percentage for the Prior Period either in Values or as Percentage to Sales. During the Forecast Period enter the Operating Profit / Margin either uniform for all the years or for each individual year. In the case of start-ups, if the Sales were zero in the previous and or subsequent years, the user must enter Operating Profit Values and not a percentage, until the time there are Sales.

Incremental Investment Rate is Incremental Fixed Asset Rate plus Incremental Net Working Capital Investment Rate.

The Incremental Fixed Assets Investment represents the Net Investments in Fixed Assets and Intangibles (Net Block of Fixed Assets). The Fixed Asset Investments forms a part of Company’s operations to support Sales Growth. This Investment Rate can be expressed as a percentage of Incremental Sales.

The Incremental Fixed Assets Investment is defined as Capital Expenditures less Depreciation expense for the year.

Incremental Fixed Assets Investment = Capital Expenditures – Depreciation expense

And can be expressed as

The Incremental Net Working Capital (NWC) Investment represents the Investments in Current Assets less Current Liabilities.The Incremental Net Working Capital Investments forms a part of Company's operations to support Sales. Short-term borrowings should be excluded from Current Liabilities and will form a part of Debt and Obligations.

This Investment can be expressed as a percentage of Incremental Sales Growth.

When using the App, the user must enter the Incremental NWC Investment either in Values or as Incremental NWC to Incremental Sales Rate. The user can enter the Incremental NWC Investment / Rate uniform for all the years or for each individual year. In the case of start-ups, if the Sales were zero in the previous and or subsequent years, the user must enter Incremental NWC Investment in Values and not a percentage, until the time there are Sales.

The Income Tax Rate represents taxes on the Operating Profit for a year, which a Company is likely to incur during the Forecast Period. There could be a difference in the Cash Income Tax Rate and the Income Tax Rate due to Company polices of recognizing some revenue and expense items at different times, for financial accounts and tax accounts.

When using the App, the user must ideally enter the Marginal Income Tax Rate, the Company is likely to incur during the Forecast Period and not the Cash Income Tax Rate, since any excess or less Tax paid, would be set off in the subsequent years.

Income Tax Rate during the Residual Period is the rate companies expect to pay during the post-Forecast Period. This should be the Marginal Income Tax Rate.

When using the App, the user must enter the Residual Income Tax Rate expected during the Residual period.

Example for computing Net Cash Flow of Joy Sweets

Assumptions

Computation of Net Cash Flow

Table 1.2

We have now computed the Cash Flows from operations for Joy Sweets based on various parameters or value drivers.

We also need to arrive at a Present Value of these Cash Flows for which we require a Cost of Capital to discount the Cash Flows. The Cost of Capital is explained in the Capital Structure section.

The Company may have Non-Operating Assets not utilisied for generating Operating Cash Flows.

We therefore require Balance sheet items, which will consist of

• Non-Operating Assets not utilized to generate Operating Cash Flows and
• Liabilities such as Debt, Minority Interest and Other Liabilities

To be added or subtracted to arrive at the Shareholder Value.

Non-Operating assets are those Assets that are not required for generating Operating Cash Flows. These could be Cash & Securities, Investments, Other Assets etc.

This is the Cash and Securities at Market Value including short-term Investment as on the Prior Period ending for the Company.

When using the App the user must enter the Cash and Securities for the Prior Period.

This is the Investments in the books as on the Prior Period. This would be the estimated Market Value of Investment in Subsidiaries or Joint Venture or Other Partnerships for which the financial information would not be consolidated and no part of it should form a part of the Profit and Loss Account.

When using the App, the user must enter the Investments at Market Value if any as on the Prior Period ended.

The items in Other Assets could include Deferred Tax Assets and other Non-Operating Assets and expected Contingent Assets. The Income from these Assets should not be considered as Revenue / Sales.

This is the Market Value of Minority Interest. This should be entered if the Company is being valued on consolidated basis for these Investments and there is a Minority Interest.

When using the App, the user must enter the Minority Interest if any as on the Prior Period ended.

This should include Deferred Tax Liabilities, Non-Interest Bearing Obligations, Under Funded Pensions and Health Care Obligations and Expected Contingent Liabilities as on Prior Period Ended.

This is the Value of Debt and Interest Bearing Obligations as on Prior Period Ended. The Debt portion should include Short Term Borrowings.

These are Losses in the books as on the Prior Period ended. The model assumes that the losses will be set off against any future profits until the Target Year. The Target Year is the last year of the Forecast Period.

When using the App, the user must enter the Carry Forward Losses figure. This will offset the Income Tax payable in future years until the last year of the Forecast Period.

The App ignores any Carry Forward Loss post Forecast Period.

Outstanding shares is the Company’s Stock / Shares currently held by all its Shareholders. This should include Equity Options, Convertible Shares and Warrant Options.

When using the App, the user must enter the number of outstanding shares as on the Prior Period ended.

Market Capitalization is the Market Value of a Company’s outstanding shares. This is calculated by multiplying a Company’s outstanding shares by the current market price of a share.

When using the App, the user must enter the Market Capitalization or in case of early stage companies the estimated latest Valuation of the Company - usually the Valuation as on the last round of funding. Entering this figure is necessary since the Debt Equity Ratio is computed based on the Market Value of the Company’s Equity.

We compute the Debt Equity Ratio based on Market Values since Investors demand returns on Market Valuation and not Book Value.

The user can either use the Debt Equity Ratio as computed based on Market Capitalization or Change the Debt Equity Ratio if the user expects the Long Term Debt Equity Ratio to be different from the Ratio computed based on the Market Capitalization. The app will then use the revised Debt Equity Ratio to compute WACC, while ignoring computation based on Market Capitalization.

When using the App, the user must enter the Debt Equity Ratio only if the user expects it to change during the Forecast Period or has not entered the Market Capitalization.

We need to arrive at a Present Value of Operating Cash Flows for which we require a Cost of Capital to discount the Cash Flows.

We use the Weighted Average Cost of Capital (WACC) to compute the Cost Of Capital and discount the Cash Flows by the WACC. WACC is the weighted average Cost of Debt and Equity Capital. For example, if a Company’s pre-tax Cost of Debt is 10%, estimated Cost of Equity 15%, Income Tax Rate is 30%, and it finances its business growth by Debt 40% and Equity 60%, then the Weighted Average Cost of Capital would be computed as follows:

Table 1.3

Note:

1. Post tax Cost of Debt equals Cost of Debt (1 - Tax Rate) = 10% * (1 - 30%) = 7%
2. Cost of Capital is also called Weighted Average Cost of Capital (WACC)

Cost of Debt is the expected Cost of Long Term Debt. The Intrinsic Value involves forecasting Future Cash Flows and discounting it by future discount rates. The model assumes the Cost of Debt to remain uniform during the forecast period. The Cost of Debt should be the Cost of Debt of the Currency in which the Company is being Valued.

The Cost of Debt is Pre-tax and in Nominal terms is measured as follows:

Real Interest Rate + Expected Inflation Rate + Default Spread.

Hence, if the Cost of Debt would be 9.75% and Income Tax Rate at 33% then the after tax Cost of Debt will be 9.75% (1 - 33%) = 6.53%.

In the App, the user must enter the Pre-tax Cost of Debt in nominal terms.

The Real Interest Rate is the rate of interest an investor or lender receives (or expects to receive) after factoring inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the Nominal Interest Rate minus the Inflation Rate.

A Risk Free Rate is a rate of return on Investment with no risk or financial loss. This is a Bond Treasury Rate issued by the government. Risk Free Rate varies from country to country and from currency to currency.

Risk Free Rate = Real Interest Rate + Expected Inflation.

Please note that Risk Free Rates vary across varying time horizons and should be consistent with Forecast Period while doing Valuation.

Default Spread is the difference between the Cost of Debt to the borrower and the Risk Free Rate.

Expected Inflation is the Expected Inflation Rate of the Currency during the forecast period. It is normally built in to the Risk Free Rate.

To elucidate: For a country in 2016, the Real Interest Rate is 2% and the Expected Inflation is 5.25%. If a Company’s default spread is 2.5% then the Pre-tax Cost of Debt is 9.75%. It is necessary to understand that the Risk Free Rate is Real Interest Rate + Expected Inflation Rate which is 2% + 5.25% = 7.25%

When using the App, the user must enter the Pre-tax Cost of Debt in nominal terms.

Cost of Equity is an expected rate of return required by the investors to invest in the Company’s shares. The Equity Investors generally require a risk-free rate plus an additional return called Equity Risk Premium (ERP) for investing in a Company’s shares to compensate for the risk undertaken by the investors.

The model that explains the relationship between the systematic risk and the expected return on Assets, particularly stocks, is referred to as The Capital Asset Pricing Model (CAPM). This model is used extensively to evaluate risky securities, expected returns on Assets based on the risk level of the Assets, and for calculating the Costs of Capital.

The formula for calculating the expected return of an asset given its risk is as follows:

Simply,

Cost of Equity = Risk Free Rate + Equity Risk Premium, where

Risk-free Rate = Real Interest Rate + Expected Inflation Rate

Equity Risk Premium = Beta (Expected Return on Market - Risk Free Rate)

The Expected Return on Market represents the additional return expected by investors to invest in the Equity market versus risk-free government bonds.

The Beta coefficient is the measure of volatility or systematic risk of the stock in comparison to the market as a whole. The individual stocks tend to be riskier or less risky than the market and the Beta measures this risk. Beta is easily obtainable from various financial online sites.

The expected Return on Equity varies across investor types. For example, venture capitalists would demand higher returns than a stock market investor. Returns also depend on lifecycle stage of a Company.

In case the user finds computing Beta and Cost of Equity under the Capital Asset Pricing Model (CAPM) cumbersome, then the user may use a hurdle rate as Cost of Equity or Stock Market Expected Returns on Equity, or any other reference as the Cost of Equity.

When using the App, the user must enter the Cost of Equity for the Forecast Period. This may be uniform for all the years or the user can opt to enter the Cost of Equity individually for each year.

The Expected Market Return is the return expected by the Investors for an Investment made in companies represented in the Index. The Expected Market Return is an important concept in risk management, because it is used to determine the market risk premium. The Market Risk Premium, in turn, is part of the Capital Asset Pricing Model, (CAPM) formula.

The returns on individual stocks may be considerably higher or lower depending on their volatility relative to the market represented by Beta of the Stock.

One way to compute Expected Market Return is to add the Expected Inflation Rate and the Real Returns (Returns Over Inflation in the Stock Market).

The Real Return (Market Return plus Dividend Yield Less Inflation) for the S&P 500 as analysed for a period of 100 years (1918 – 2017) and the Geometric Average is about 7.13% over Inflation.

It is possible to compute the Expected Market Returns by adding the Expected Return Over Inflation (Real Return) to Inflation. Hence, if the inflation rate is 2%, the Expected Market Return will be about 9.13% (2%+7.13%).

This Method could also be looked into to compute the Expected Market Returns.

Thus, to Compute the Cost of Equity of a Stock one may use the following formulae:

Inflation + Beta or Adjusted Beta of a Stock * ERI

It is advisable to check the expected the Risk-Free Rate and the Rate of Inflation prior to computing the Expected Market Returns.

Example of Joy Sweets for Computing WACC / Cost of Capital

Table 1.4

Present Value of Cash Flows

In the following table, we discount the Cash Flows of Joy Sweets with Cost of Capital (WACC) computed above.

Table 1.5

As mentioned earlier in this section the Free Cash Flows over the Forecast Period represent the first part of a Company’s value. The model values Companies as a going concern thus a Company continues to have value post the Forecast Period – the Cash Flows continue to remain.This part of the Cash Flow (Post Forecast Period) is called Residual Value or Terminal Value.

Residual Value is the value of a Company post the Forecast Period and it is assumed the owners will earn only the minimum required rate of return. Residual Value often constitutes most of a Company’s total value.

We have used the Perpetuity with Real Constant NOPAT Model to compute Residual Value. This model assumes that any future Investments, beyond the Forecast Period, would not create value and a Company would be able to sustain its Net Operating Profit after Tax (NOPAT) in real terms post the Forecast Period.

This is because in order to survive, companies would need to cope with long-term inflationary pressures.

The Perpetuity with Real Constant NOPAT Model in other words assumes that the NOPAT will cope up with the inflation and thus grow in perpetuity at the Inflation Rate, in the post-Forecast Period or will remain constant in real terms. The formula for the Present Value of Residual Value is that of a growing perpetuity as follows:

1. NOPAT in Target Year. Thus estimating the Target Year Operating Profit thus forms a crucial parameter in arriving at a Valuation

Present Value of Residual Value = Residual Value x Discount Factor at end of Forecast Period.

Cost of Debt in Real Terms = Cost of Debt – Expected Inflation Rate

The App automatically computes Cost of Debt in real terms by deducting expected inflation. There is no entry point in the App for Cost of Debt in real terms.

Cost of Equity in Real Terms = Cost of Equity – Expected Inflation Rate.

The App automatically computes Cost of Equity in real terms by deducting expected inflation. There is no entry point in the App for Cost of Equity in real terms.

This is the Cost of Equity expected during the Residual Period. This should be closer to Market Returns since it is expected that companies would become Mature Companies during the Residual Period.

The app automatically computes Cost of Equity in Real Terms by deducting the Inflation Rate.

When using the App, the user must enter The Cost of Equity during Residual Period in nominal terms.

In the Perpetuity Real Constant NOPAT Model, it would be required to divide the NOPAT by WACC in real terms. The computation of WACC in Real Terms is shown in the example below:

Example of Computation of WACC Real in computing Residual Value for Joy Sweets:

Table 1.6

Table 1.7

Computation of Present Value of Residual Value Of Joy Sweets

Thus the Valuation of Joy Sweets is computed as follows:

Table 1.8

When using the App, the user must enter the requested data and information in the Know Your Worth module to get:

• Valuation Report
• Shareholder Value Augmented Report (Explained in the Value Augmentation Section)

Now that the estimation procedures for the calculation components of Shareholder Value-Cash Flow from operations, Cost of Capital, and Residual Value, have been explained, let us look at an illustration that incorporates all of the components. Consider a business Snap Value with the following five-year forecast:

Table 1.9

SVAg is the difference in Shareholder Value between two time periods. Total SVAg denotes the Shareholder Value Augmented during the Forecast Period. For more details please refer to FAQs on Value Augmentation.

Future Value Per Share is derived by the process of compounding the Present Value Per Share by the Cost of Equity used to discount the Cash flows for that year.

Expectations Valuation is a concept that deals with the Stock Market Prices and based on those, it is possible to analyze and understand the Expectations Value Drivers built in to the Stock Market Price and also supports decision making. This helps the Investors and Businesses to determine whether a stock is undervalued or overvalued and practise Value Investing. The tool is valuable for both, Investors and Businesses.

In the earlier section, we showed how to arrive at Shareholder Value of a Company using Discounted Cash Flows (DCF). Here we use the same Concepts but we start with the Market Capitalization / Estimated Valuation to arrive at the Shareholder Value. In other words, Expectations Valuation Concept is an inverse computation from Market Capitalization to Expectations Value Drivers.

The process is similar to arriving at the Shareholder Value. Here we start estimating the Cash Flows and discount it by the Cost of Capital to arrive at the Shareholder Value and we continue the process until we equate the Shareholder Value to the Market Value to arrive at the Expectations Value Drivers. The price to value equation is derived through a sound iteration process.

We start with the Prior Period information and Basic information and these include Currency in which the company is being valued, the Sales and Operating Profit Margin in the Prior Period, Income Tax in Forecast and Residual Period as well as the Non-Operating Assets of the Balance Sheet, such as Cash and Securities, Investments and Other Assets, Minority Interest and Other Liabilities. As well as Debt and Obligations, Carry Forward Losses, Outstanding Shares and Market Capitalization. All of these have been explained in the Know Your Worth Module. Then we start estimating the Cash Flows and discount it by the Cost of Capital to arrive at the Shareholder Value and we continue the process until we equate it to the Market Value.

The illustration below explains and demonstrates the steps required to arrive at the Expectations Value Drivers of Z Media under two Scenarios, which will equate the Shareholder Value equivalent to its Market Capitalization.

Assumptions for Z Media

In the app, there are Nine Value Drivers in the Expectations Valuation Module that can be iterated.

1. Forecast Period

The first Value Driver is the number of years of Free Cash Flows on which the Valuation is based on. How many years the user estimates Shareholder Value to be created? This can range from a single year up to 30 years depending upon the industry dynamics, market strategy, opportunity, barriers to entry and competitiveness. This will help to ascertain how many years of Forecast Period the Market is building in the Stock Price.

In the case of Z Media we assume 15 years and 20 years Forecast Period and proceed. In case we are unable to equate Values then on can also come back and Iterate.

2. Expected Inflation Rate

In this step, we need to estimate the Long Term Expected Inflation Rate of the Currency we are valuing the Company in. For instance, the Long Term Inflation Rate of Indian Rupee is say 4%. We must take care of the inflation built in other inputs such as, Cost of Debt and Cost of Equity to be consistent with the inflation assumptions.

3. Sales Growth Rate (CAGR)

The next step is estimating the expected Sales Growth Rate (CAGR) for the Forecast Period. This is based on the Market Opportunity, Industry dynamics, Company’s Strategy etc.

For Z Media we have assumed a CAGR of Sales to be 16% and 14% for 15 years and 20 years respectively.

4. Target Operating Profit Margin

The next step in the process is estimation of the Target Operating Profit Margin at the end of the Forecast Period. What will be the margin the company will attain by the end of the Forecast Period or during its mature stage?

Operating Profit is the key driver in computing the Residual Value, thus the user needs to ascertain carefully the Operating Profit Margin for the Target Year.

The benefit of the App is that it equates and equalizes the difference between the Operating Profit Margin of the Year Prior with the Target Year.

For Z Media we assume Target Operating Profit Margin of 22% in the 15th year and 20th year.

5. Incremental Fixed Asset Investment Rate

This is the step in the process of iteration where the user would need to estimate the Incremental Fixed Assets (including intangibles) Investment Rate.

Incremental Sales

The Company to grow its sales during the Forecast Period will need to Invest in Incremental Fixed Assets.

For Z Media we assume Incremental Fixed Asset Investment Rate to be 22% during the Forecast Period under both the Scenarios.

6. Incremental Net Working Capital Investment Rate

This is the step in the process of iteration where the user would need to estimate the Incremental Net Working Capital Investment Rate

The Company to grow its sales during the Forecast Period will need to Invest in Incremental Working Capital.

For Z Media we assume Incremental NWC Investment Rate to be 22% during the Forecast Period under both the Scenarios.

7. Cost of Debt

This step the user needs to estimate the expected future cost of Pre-tax Long Term Debt in Nominal terms.

The user should review the Forecast Period, Expected Inflation Rate, and Risk Free Rate for the Currency and the Default Spread for the Company before entering this data.

In the illustration of Z media we take the Cost of Debt as 8.5% for both the scenarios.

The Cost of Debt can be broken down theoretically as the Inflation Rate + Real Interest Rate + Default Spread where, say, Inflation Rate is 4%, Real Interest Rate is 2.5% and the Default Spread is 2%.

8. Cost of Equity

In the next step the user needs to estimate the Cost of Equity. This could be based on Capital Asset Pricing Model (CAPM), Other Models or could just be the implicit return rate of the market or as investors require. The user must enter the Cost of Equity in Nominal Terms.

For Z media, we take the Cost of Equity as 13.5% for both the scenarios.

As per the Capital Asset Pricing Model the Cost of Equity can be theoretically broken down into Equity Risk Premium + Risk Free Rate (Real Interest Rate + Inflation Rate).

9. Cost of Equity Residual

In this step the user must estimate the Cost of Equity expected during the Residual Period. This should be closer to Market Returns since it is expected that companies would become Mature Companies during the Residual Period. The user must enter the Cost of Equity for Residual Period in Nominal Terms.

For Z media, we take the Cost of Equity as 13.5% for both the scenarios.

As per the Capital Asset Pricing Model the Cost of Equity can be theoretically broken down into Equity Risk Premium + Risk Free Rate (Real Interest Rate + Inflation Rate).

The FAQs with regard to Know Your Worth will provide a detailed explanation of the terms and value drivers mentioned above.

If we compute the Shareholder Value based on the above expectations we get the following results:

Table 2.1

After estimating the Expectations Value Drivers, we now compare the Market Capitalization with the Shareholder Value. As it is evident, the Shareholder Value does not equate with the Market Capitalization.

Hence, we now proceed to Iterate the Value Drivers to get the equation between Price and Value.

We now address the gap by using our skill and judgment to change any of the Expectations Value Drivers and continue iterating until we equate the Shareholder Value to Market Capitalization under both the Scenarios.

We iterate the Expectations Value Drivers for the two Scenarios as follows:

Table 2.2

In the above example we have changed the Forecast Period, CAGR of Sales and Target Operating Profit Margin to equate the Shareholder Value to Market Capitalization.

The user can change any of the Expectations Value Drivers to equate.

Expectations Valuation is a continuous and frequent process as companies stock prices respond to earnings, disclosures of new information, competition, strategies and news on a regular basis and in most cases, the magnitude of changes could be significant. The user is able to match the thought process of the market and understand the existing equation between price and value, through the process of Expectations Valuation.

The App helps you to undertake this exercise quickly in minutes in one Screen.

Expectations Valuation can be done for any type of company. In fact, it is very important for both Entrepreneurs and Investors to understand what is getting built in a Valuation and what the Expectations are.

Yes it can be done.

In the App, the user can get detailed reports for the two Scenarios on:

• Cash Flow Report
• Valuation Report

The Expectations Valuation FAQs is best understood while undertaking an example in the App and reading it along with the Tool Tips.

PErception is a Concept Module that deals with the Stock Market Prices, Price Earnings Multiple, Cost of Equity and Earnings Growth and based on these it is possible to:

• Value the Company based on its Earnings Growth
• Understand what P/E drivers are built in the Stock Price.
• Compute the Forward P/E Multiples based on the Earnings Growth Forecasted.

This Section of the FAQ assumes that the reader has understood the Discounted Cash Flow (DCF) Valuation explained in the earlier section of the FAQs.

P/E ratio is Price Earnings Multiple. The Price-Earnings ratio (P/E ratio) is the Price divided by the Earnings Per Share of the Company for the period.

What's Your P/E is a Module that helps you to arrive at P / E of a Stock based on the Earnings Growth (Net Income or PAT) Forecasted and the Cost of Equity of the Company. The Model discounts the Future Earnings by the Cost of Equity to arrive at the Present Value (Discounted Future Earnings Model). It can also be used to find Equity Value of a stock based on Earnings and its Growth.

Expected Inflation is the Expected Inflation Rate of the Currency during the forecast period. It is normally built in to the Risk Free Rate.

Net Income is Profit After Taxes and after Preferred Dividend.

Prior to any Valuation, it is imperative to know the Number of years for which Valuation is to be based on. This could be from a single year to 15 years and if companies have significant competitive advantage then these could be over 15 years and even go upto 30 years.

The model used in the App, assumes that post the Forecast Period, the company will be able to sustain its Net Income (Profit After Tax) in real terms. The App permits the Forecast Period to be a maximum of 30 Years.

When using the App, enter the number of years for which the Valuation is to be based on. The maximum period of forecast in the app is limited to 30 years.

Equity Value is the sum of Cumulative Present Value of Earnings during the Forecast Period and the Present Value of Earnings during the Residual period.Here is an illustration to explain the computation

Cost of Equity is an expected rate of return required by the investors to invest in the Company’s shares.

The model that explains the relationship between the systematic risk and the expected return on Assets, particularly stocks, is referred to as The Capital Asset Pricing Model (CAPM). This model is used extensively to evaluate risky securities, expected returns on Assets based on the risk level of the Assets, and for calculating the Cost of Equity for the Forecasted period.

The Equity Investors generally require a Risk-Free Rate plus an additional return called Equity Risk Premium (ERP) for investing in a Company’s shares to compensate for the risk undertaken by the investors.

Equity Risk Premium = Beta (Expected Return on Market - Risk Free Rate).

In case the user finds computing Beta and Cost of Equity under the Capital Asset Pricing Model (CAPM) cumbersome, then the user may use a hurdle rate as Cost of Equity or Stock Market Expected Returns on Equity, or any other reference as the Cost of Equity.

The Cost of Equity varies across investor types. Cost of Equity also depends on the lifecycle stage of a Company.

The Cost of Equity for the Residual period should be closer to Market Returns since it is expected that companies would become Mature Companies during the Residual Period.

A P/E Forward ratio is a Equity Value (Present Value) of the Stock divided by the EPS for the Forecast Year.

Future Value Per Share is derived by the process of compounding the Present Value Per Share by the Cost of Equity used to discount the Cash flows for that year.

Decrypt Stock P/E is Price to Earnings multiple that deals with the Stock Market Prices, Price Earnings Multiple Cost of Equity and Earnings Growth and based on these it is possible to understand what P/E drivers are built in the Stock Price (Price Scenario) and build own Expectations in the Value Scenario and understand the gap that exists between Price and Value. This supports decision making. This helps the Investors and Businesses to determine whether a stock is undervalued or overvalued and practise Value Investing.

The Model Discounts the Future Earning by the Cost of Equity (Discounted Future Earnings Model).

In the earlier section, What’s Your P/E we showed how to arrive at Equity Value of a Company using Discounted future Earnings. Here, we use the same Concepts, but we start with the Market Capitalization / Estimated Valuation to arrive at the Equity Value. In other words, Decrypt Stock P/E Concept is an inverse computation from Market Capitalization to Expectation P/E Drivers.

We start with the Prior Period information and Basic information and these include Currency in which the company is being value, the Outstanding Shares and the Figures In which the value needs to be computed. Then by using the P/E drivers we can equate the Equity Value with the Market Price in the Price Scenario and determine the difference between the price and value by assuming P/E drivers in the Value Scenario.

The illustration below explains and demonstrates the steps required to arrive at the Expectation P/E Drivers of Z Media under the Price Scenario which will equate the Equity Value equivalent to its Market Price. Under the Value Scenario we build our own Expectations of P/E Drivers and understand the Gap that exists between Price and Value.

Assumptions of Z Media

In the app, there are Eight P/E Drivers in the Expectations Valuation Module that can be iterated under Price Scenario to understand what’s built in the Equity Value

1. Market Price

   This is the current Market Price of the company which is currently trading in the Stock Market. The Market Price can be last traded Price or the Price on date of the Company’s previous reported Financial Results.

   In the case of Z Media, we assume Market Price to be 40 and proceed.

2. P/E Ratio

   This is the Ratio of the Price to Earnings of a Company for valuing a company that measures its current share price relative to its per-share earnings.

   In the case of Z Media, we assume the P/E Ratio to be 11 and proceed.

3. EPS

   This is the Earnings Per Share of the company. This is a computed figure and is computed by dividing the Market Price by the P/E Ratio of the Company.

   In the case of Z Media, the EPS is 3.64 i.e. Market Price (40) / PE Ratio (11).

4. Forecast Period

   The Forecast Period is the number of years of Free Cash Flows on which the Valuation is based on. This can range from a single year up to 30 years depending upon the industry dynamics, market strategy, opportunity, barriers to entry and competitiveness. This will help to ascertain how many years of Forecast Period the Market is building in the Stock Price.

   In the case of Z Media, we assume 10 years Forecast Period and proceed. In case we are unable to equate Equity Value to Market Price then one can also come back and iterate. This is done under the Price Scenario.

5. Expected Inflation Rate

   In this step, we need to estimate the Expected Inflation Rate of the Currency we are valuing the Company in.

   For instance, the Expected Inflation Rate of Indian Rupee is say 4%.

   We must take care of the inflation built in other inputs such as, Cost of Debt and Cost of Equity to be consistent with the inflation assumptions.

6. CAGR of EPS

   The next step is estimating the expected CAGR of EPS for the Forecast Period. This is based on the Market Opportunity, Industry dynamics, Company’s Strategy etc.

   For Z Media we have assumed a CAGR of Sales to be 7.5% for 10 years.

7. Cost of Equity

   In the next step the user needs to estimate the Cost of Equity. This could be based on Capital Asset Pricing Model (CAPM), Other Models or could just be the implicit return rate of the market or as investors require. The user must enter the Cost of Equity in Nominal Terms.

   For Z media, we take the Cost of Equity as 13%.

   As per the Capital Asset Pricing Model the Cost of Equity can be theoretically broken down into Equity Risk Premium + Risk Free Rate (Real Interest Rate + Inflation Rate).

8. Cost of Equity Residual

   In this step the user must estimate the Cost of Equity expected during the Residual Period. This should be closer to Market Returns since it is expected that companies would become Mature Companies during the Residual Period. The user must enter the Cost of Equity for Residual Period in Nominal Terms.

   For Z Media, we take the Cost of Equity in Residual Period as 13%.

We now address the gap by using our skill and judgment to change any of the P/E Drivers and continue iterating until we equate the Market Price with the Equity Value in the Price Scenario. We iterate the P/E Drivers for Price Scenario and also build our own assumptions under the Value Scenario as follows:

In the above example (Price Scenario) we have changed the CAGR of EPS, Cost of Equity in Forecast and Residual Period.

P/E Stock Valuation is a continuous and frequent process as company’s stock prices respond to earnings, disclosures of new information, competition, strategies and news on a regular basis and in most cases, the magnitude of changes could be significant. The user is able to match the thought process of the market and understand the existing equation between price and value. The App helps you to undertake this exercise quickly in minutes in one Screen.

Yes, it can be done.

In the App,the user can get detailed reports for the two Scenarios:

• P/E Report
• Valuation Report

The P/E Valuation FAQs is best understood while undertaking an example in the App and reading it along with the Tool Tips.

Decrypt Index P/E is Price to Earnings multiple that deals with the Index Prices, Price Earnings Multiple, Expected Market Returns and Earnings Growth and based on these it is possible to understand what P/E drivers are built in the Index Price (Price Scenario) and build own Expectations in the Value Scenario and understand the gap that exists between Price and Value. This supports decision making. This helps the Investors to determine whether an Index is undervalued or overvalued and practise Value Investing.

The Model Discounts the Future Earning by the Expected Market Returns (Discounted Future Earnings Model).

We start with the Prior Period information and Basic information and these include Currency in which the Index is being valued, which the value needs to be computed. Then by using the P/E Drivers we can equate the Index Value with the Market Price in the Price Scenario and determine the difference between the Price and Value by assuming P/E drivers in the Value Scenario.

The illustration below explains and demonstrates the steps required to arrive at the Expectations P/E Drivers of Nifty under the Price Scenario which will equate the Index Value equivalent to its Index Price. Under the Value Scenario we build our own Expectations of P/E Drivers and understand the Gap that exists between Price and Value.

Assumptions of Nifty

In the app, there are Eight P/E Drivers in the Decrypt Index P/E Module that can be iterated under Price Scenario to understand what’s built in the Index Value

1. Index Price

This is the current Index Price of the Index.

In the case of Nifty, we assume Index Price to be 10,600 and proceed.

2. P/E Ratio

This is the Ratio of the Price to Earnings of an index.

In the case of Nifty, the P/E Ratio as on October 31, 2018 to be 24.92 and proceed.

3. EPS

This is the Earnings Per Share of the index. This is a computed figure and is computed by dividing the Index Price by the P/E Ratio of the Index.

In the case of Nifty, the EPS is 425.36 i.e. Index Price (10600) / PE Ratio (24.92).

4. Forecast Period

The Forecast Period is the number of years on which the Valuation is based on. This can range from a single year up to 30 years depending upon the economic and political scenario, future market expectations and global indices. This will help to ascertain how many years of Forecast Period the Market is building in the Index Price.

In the case of Nifty, we assume 10 years Forecast Period and proceed. In case we are unable to equate Index Value to Market Price then one can also come back and iterate. This is done under the Price Scenario.

5. Expected Inflation Rate

In this step, we need to estimate the Expected Inflation Rate of the Currency we are valuing the Index in. For instance, the Expected Inflation Rate of Indian Rupee is say 3.11% for October 2018.

We must take care of the inflation built in other inputs such as, Expected Market Returns to be consistent with the inflation assumptions.

6. CAGR of EPS

The next step is estimating the expected CAGR of EPS for the Forecast Period. This is based on the strength of the economy, GDP growth and economic policies.

The next step is estimating the expected CAGR of EPS for the Forecast Period. This is based on the strength of the economy, GDP growth and economic policies.

7. Expected Market Returns Forecast Period

The Expected Market Returns or Implicit return rate of the market should be measured in Nominal Terms.

The Real Return (Market Return plus Dividend Yield Less Inflation) for the S&P 500 as analyzed for each span of 30 years over a period of years, has been ranging between 5.23% to 8.02% with a CAGR of about 7.13% for 100 years.

It is possible to compute the Expected Market Returns by adding the Real Return to Expected Inflation Rate. This may vary depending on the risk investors would be willing to bear. Hence, if the inflation rate is 3.11 %, the ERI is 7.13% the Expected Market Return will be 10.24%.

To calculate – please input the Expected Market Returns for the Index, which should be uniform for all the years in the forecast period. It is advisable to check the Risk-Free Rate and the rate of inflation prior to entering the Expected Market Returns.

For Nifty, we take the Expected Market Return as 10.24%

8. Expected Market Returns Residual Period

This is the Expected Market Returns during Residual Period (After the Forecast Period). This is in Nominal terms.

For Nifty, we take the Expected Market Return in Residual Period as 10.24%.

We now address the gap by using our skill and judgment to change any of the P/E Drivers and continue iterating until we equate the Index Price with the Index Value in the Price Scenario. We iterate the P/E Drivers for Price Scenario and also build our own assumptions under the Value Scenario as follows:

P/E Index Valuation is a continuous and frequent process as an Index responds to earnings, disclosures of new information and news on a regular basis and in most cases, the magnitude of changes could be significant. The user is able to match the thought process of the market and understand the existing equation between price and value.

The App helps you to undertake this exercise quickly in minutes in one Screen.

Yes it can be done.

In the App,the user can get detailed reports for the two Scenarios on:

• P/E Report
• Valuation Report

The P/E Valuation FAQs is best understood while undertaking an example in the App and reading it along with the Tool Tips.

Any activity undertaken to:

• Increasing Sales Growth Rate. (Assuming Company Earns > Cost of Capital)
• Increasing Operating Profit Margins
• Reducing Income Tax Rate
• Reducing Cost of Capital such as changing financial mix
• Reducing Incremental Fixed and Working Capital Investment Rate
• Increasing Growth Duration (Forecast Period) through long-term competitive advantages

Will lead to Value Augmentation. In other words, such a process should affect future Cash Flows positively, to augment value.

Shareholder Value Augmented (SVAg) addresses the change in value over the Forecast Period. Value Augmentation can happen only if the Investments earn in excess of the Cost of Capital required by the Capital Market. Thus,

Shareholder Value Augmented =   (Cumulative Present Value of Cash Flows + Present Value of Residual Value at the end of Forecast Period)
- (Residual Value in the Prior Period + Cumulative Present Value of Cash Flows in Prior Period)

Value Augmentation is best demonstrated in the example in Table 3.1 where the total Shareholder Value Augmented by this five-year strategy is 334. The year–by–year increase in value is calculated by annual change in the Cumulative Present Value of Cash Flows plus Present Value of Residual Value’s total.

Shareholder Value Augmented for Joy Sweets:

Table 3.1

Where, PV is Present Value, CCF is Cumulative Cash Flow and RV is Residual Value

There are 3 sub-modules in Value Augmentation:

• Value Impact
• Share Buyback
• Economic Breakeven Margin

The Value Impact module assists in:

• Enabling the user to make a comparative Value Impact Analysis of Value Drivers on Shareholder Value.
• Computing 'What if Analysis' on two Value Drivers and Viewing Shareholder Value through a combination of two Value Drivers in a Shareholder Value Matrix.
• Computing 'What if Analysis' through a combination of Eight Value Drivers and being able to view Shareholder Value in the Value Driver Impact Table.

To make a Comparative Value Impact Analysis means ascertaining the effect of the various value drivers on Shareholder Value. Evaluating this process is the case below, demonstrated through the illustration:

Summary Illustration: Comparative Value Impact Analysis

If we compute Shareholder Value for an increase of 1% (18% becomes 18.18% not 19%) for a Value Driver while keeping other Value Drivers constant, we see the following results in Table 3.2:

We need to input the percentage change (for example 1% change) to view the Comparative Impact of this change, on all Value Drivers on Shareholder Value. (The change while computing will show the effect of each value driver while other value drivers will remain neutral). The input box will display the base and the change percentage for all the value drivers.

Table 3.2

The maximum positive impact of change appears in the Operating Profit Margin. The Shareholder Value increases from 121.34 to 122.88 and maximum negative impact of change appears in Cost of Debt where Shareholder Value decreases by 0.60

When using the App, the user must enter the basic data requested and enter a common change percentage for all the variables. The App will calculate the Comparative Value Impact of Value Drivers as shown in Table 3.2.

Shareholder Value Matrix allows us to view the impact of two Value Driver combinations on Shareholder Value. The Shareholder Value Matrix is based on a combination of two variables, Sales Growth and Operating Profit Margin.

We must enter the four different percentage rates for each of the Value Drivers as shown below. Table 3.3 and Table 3.4 display the result in form of a Shareholder Value Matrix.

Shareholder Value Matrix Inputs

Table 3.3

Shareholder Value Matrix

Table 3.4

Shareholder Value / Share Matrix

When using the App, the user must define the two Value Drivers: Target Operating Profit Margin and Sales Growth, to Compute the Shareholder Value Matrix. Refer Table 3.3 and Table 3.4 as examples.

The Value Driver Impact Table illustrates the What If Analysis of the impact that the varying combinations of the Eight Value Drivers have on Shareholder Value. Four such Senarios are possible per Plan to view the impact on Shareholder Value and Shareholder Value per share.

An illustration for four different Combinations of the Eight Value Drivers is given as an example of Heritage Industries below:

Summary Illustration: Value Driver Impact Table

Table 3.5

If we compute the Shareholder Value for all the Combinations, we can View the results in Table 3.5 where SV / Share denotes Shareholder Value per Share.

When using the App, the user must define up to Four Scenarios of the Eight Value Drivers, and view the Shareholder Value for these combinations.

A Share Buyback is a program by which a Company buys back its own shares from the market place, usually because the management believes the Shares are undervalued.

There are primarily four reasons why companies buy back their shares:

• When the stock market is valuing the Company way below its Intrinsic or Economic Value
• When there are no value augmenting Investment opportunities available.
• To tax efficiently return excess cash to the shareholders.
• To increase Financial Leverage, reducing its Cost of Capital

The following steps illustrate how to evaluate a Share Buyback Program:

• Determine the Economic Value of the Company and Economic Value per share (Based on Discounted Cash Flow (DCF))
• Compare the Value arriving above with the current Market Capitalization to determine extent of under Valuation
• Define the Share Buyback program, Number of Shares and Buyback price per share
• Build the buyback program in the model and compute the Economic Value per share post buy back and compare with Economic Value pre buy back per share.

Summary Illustration: Evaluating a Share Buyback Program of SnapValue

SnapValue (See Table 1.9 assumptions and Valuation of SnapValue) is considering a Buyback Program.

Table 1.9

The SnapValue Stock is trading at 1.50 per share and the management is considering a Share Buyback of 6 million shares at 2.25 price per share. The estimated Valuation of SnapValue based on Management Expectation is 3.7 (Table 1.9)

The Valuation of SnapValue Post Buyback is 4.7 Per Share against a Pre Buyback Value of 3.7 Per share thus it creating an Incremental Economic Value of 1.0 Per Share.

The Debt Equity Ratio in the Post Buyback Scenario is assumed and computed based on the Share buyback Valuation and the Company will maintain this ratio in the Long Term.

The Cost of Debt and Cost of Equity – Forecast and Residual is assumed to be the same in the Pre buyback Valuation and Post Buyback Valuation. If the user expects this to change due to the Share Buyback Program the user should change and compute the Post Share buyback Valuation.

See Table 3.7 for Computation of Value of SnapValue Post Buyback

Table 3.7

Note:

It is assumed that the Long Term Debt Equity Ratio will be based on the Share Buyback Valuation. In case, the user thinks that the Long Term Debt Equity Ratio will change then the user would require changing and re-entering a fresh the Debt Ratio and Equity Ratio.

When using the App, the user must enter the required inputs or if the user has already created the Valuation of this Company, then select an existing plan from Know Your Worth Module and proceed directly to fill in the Buyback Program details, Number of Shares, and Price per share.

The App will compute the Pre and Post Buyback price per share.

Economic Breakeven Margin (EBM) is the Minimum Operating Profit Margin a business needs to attain in any period to Maintain Shareholder Value for that period.

Incremental Economic Breakeven Margin can be defined as the Operating Profit Margin a Company needs to earn on its Incremental Sales equal to its Cost of Capital.

The Economic Break Even Margin can be mathematically expressed as:

BE Margin = (A + B) / C) % , where

The Incremental Economic Break Even Margin can be mathematically expressed as:

Where Incremental EBM is :

Incremental Investment Rate is the sum of Incremental Fixed Asset Investment plus Incremental Net Working Capital Investment Rate.

Summary Illustration: EBM & iEBM

To illustrate the EBM concept we present a Illustration:

Computation of iEBM

The Incremental EBM is computed below. The Computed Incremental EBM for Incremental Sales is 4.6%. You can also see in last Column of Table 3.8, the Present Value of Residual Value equates the Present Value of Free Cash Flows i.e. PV of Cash Flows + PV of Residual Value is Zero implying that if the Company wants to increase its value on Incremental Sales it must earn more than the Incremental Economic Breakeven Margin.

Computation of Economic Breakeven Margin

The computation of EBM for the business is computed below. In Column 3 of Table 3.8, we substituted the Operating Profit Margin with the computed EBM (11.8%) for the whole business. As is apparent, the Share Value Augmented is near to zero.

Table 3.8

In the App, the user must enter the requested data and information and compute:

• Economic Breakeven Margin
• Incremental Economic Breakeven Margin